All you need to know about writing covered calls
A steady passive income is something everyone wants. Of course investing your money comes with some risks, as you could also find yourself in a situation where you can lose money. But if you choose a conservative approach and invest in a diversified portfolio, write call options on the stocks you own and get access to the right tools that can provide you the best investment possibilities on the market, then you are one step closer from having a guaranteed passive income each month.
As you most likely know, a call option gives the buyer of the option the right, not the obligation, to purchase the stock at the strike price up until a fixed date. At the point when the cost of the stock goes up the call value increases.That said, you buy calls when you are expecting the underlying stock price to appreciate.
One strategy that is used by traders is to sell or write call options. When the trader owns the underlying stock, this is referred to as a ‘covered call.’ The purchaser of the call option pays a premium to have the right to purchase the stock at the strike price at a fixed date. The seller of the call option receives this premium in return for giving up his/her rights to the stock if called upon. It is this premium that is the basis for the income generation of the covered call strategy.
So what are the advantages of this strategy? There are three main ones:
1) Cash Flow
The premiums received for selling calls on existing shares provide regular cash flow in addition to the value the investor receives by owning the underlying shares.
A lot of investors buy stock with the sole purpose of writing covered calls where this can be their entire income strategy. It’s a less risky strategy which can provide steady income and is also approved for use in many retirement portfolios.
One way of employing covered calls is to buy stock of larger companies that have maintained pretty constant prices over extended periods of time and whose prices aren’t expected to soar anytime soon. Once you own the stock, you write a covered call at a strike price modestly higher than the current price. Let’s assume one of two scenarios play out:
- The stock appreciates significantly and before the expiration of the option you get a nice dividend. Not only do you get to keep the dividend but as the stock has rallied past your strike price, your call will be exercised and you will have to deliver (sell) the stock to the buyer of the call option. A win win.
- The stock depreciates and is worth less than the strike price close to expiration. You get to keep the call premium and the stock at the same time. At this point, you can issue a covered call on the same stock again in the next expiration month.
There are times when you will own stocks of good companies in your portfolio long-term. But, if you think that the stock might decline over the next few months or a year and you are not willing to sell just yet, you can hedge your long position with a covered call. You will have to keep the option premium while you see how your decision pans out. This approach works great when there is little downside risk or upside potential in the near-term, and you want to get some income while you wait for the stock to appreciate.
3) To Get a Better Selling Price
There are times you are just ready to sell a stock because of its trading near its fair value. So, you could sell a covered call at a strike price close to the current share price to increase the chance of being exercised and delivering your shares to the call option buyer.
The neat part about this is that you get extra cash via the option premium received and you are able to exit the stock at the current share price. Using covered calls with this objective is to be willing to settle for the selling price you decide on, which is the strike price.